How to Get Out of and Avoid an Upside-Down Car Loan

Most of us have to get an auto loan as a part of the car buying process.  We usually expect that our experience will be fairly simple after we drive off the car lot.  We pay off the loan by making monthly payments until the car is paid off.  What we don’t expect is that our auto loan will turn upside down while we are paying it off.

Getting upside down in a car loan can happen to any of us.  In this article, we will talk about what being upside down in an auto loan actually means.  We will also address some of the most common reasons why this happens.  Finally, we will talk about how to get out of an upside down car loan and how to avoid getting into another one.

What is an upside down car loan?

Simply stated, an upside down auto loan means the amount owed on a vehicle is more than the vehicle is worth.  The amount by which the debt exceeds the value of the car is called “negative equity”.  Obviously, we all would rather be have a loan where the value of our car is more than the amount we owe on it.

In order for you to find out if you have an upside down car loan, you need to know the value of your car as well as the remaining amount you owe to your bank or credit union.  Finding out how much you owe is relatively simple.  Visit a vehicle valuation website like Kelly Blue Book or Edmunds.  You can easily determine the value of your car.  Relevant factors include the model and trim package, the mileage and where you live.  It’s usually best to average the values from a few sites because you may get different amounts.  Finding out how much you owe on your car is easy as well.  Simply logon to your account online or look at a recent statement.  You also can call your bank to get the payoff amount of your loan.  If your loan value is higher than your vehicle’s estimated value, your loan is upside down or underwater.

How does an upside down car loan happen?

There are many reasons why your car loan might turn upside down during your payoff period.  Some of the reasons are based on the decisions you make when you buy the car and sign up for a car loan.  Other reasons are things that happen after we purchase the car.  Here are a few of the most common ways you can negative equity in your car loan:

  • High interest rate  – The higher your interest rate, the smaller the portion of your monthly payment will go towards paying down your car debt.
  • Small down payment – A relatively small down payment means you are making a small dent in the actual amount you are borrowing for the car. This means you will have more of the price of the car to pay off during the loan.
  • Long loan terms – Sometimes banks are willing to finance a car for six, seven or even eight years. The longer the term of the auto loan, the higher the chance that your vehicle’s value will one day be less than your loan amount.
  • Rapid depreciation of value – Many things can reduce the value of your car including excessive annual mileage, accidents, wear and tear and unattended repairs. The condition of your vehicle is what determines its value.

How to Get Out of an Upside Down Car Loan

The good news is there are things you can do in order to get out of an upside down auto loan. We will cover four of the most common ways to get out from under a vehicle loan with negative equity.

  • Pay Down Your Car Loan
  • Refinance Your Upside Down Car Loan
  • Sell Your Car
  • Trade Your Car

Pay Down Your Car Loan

The very best way to attack an upside down car loan is to pay down the loan balance so that the amount you owe is less than the vehicle value.  In this way, you will create “positive equity” in your vehicle.

If you’re lucky enough to have extra cash then you can make a lump sum payment.  This payment will go directly against your outstanding loan balance.  This payment will also allow you to pay your loan off sooner because you will actually be reducing the amount you owe.  If you are like most of us, you don’t have large lump sums laying around that you can throw against your loan balance.  There are other things you can do.  Whenever you can, make an extra monthly payment.  Anything extra you pay will go against your principal loan balance.  When you get some extra money like a bonus or a cash gift, consider using a part of it to reduce your auto loan.

Refinance Your Upside Down Auto Loan

Refinancing your auto loan may be the best way to attack your situation.  Your current bank may be able to help or you may need to find another lender.  A new loan with a lower rate and a shorter term will help lower your loan balance quickly.  Both of these factors will serve to help you pay more of your loan down with each monthly payment you make.  Your credit situation may have changed since you purchased your car and you may indeed qualify for a lower interest rate.  You might also be able to put an additional amount down on this new loan.

Refinancing your car loan will mean that you will need to be prepared to stay in your vehicle for longer than you intended.  Do some online research to find out what type of auto refinance loan options are available to you.  You might find an online bank or a local credit union with a special offer or a promotional interest rate. You should also use on online auto loan refinance calculator to estimate your monthly payment assuming different interest rates and terms.

Sell Your Vehicle

Another way to get out of an upside down car loan is to simply sell your vehicle.  Selling your car may not make your loan disappear.  It may however allow you to lower the negative equity with a high selling price. You may be able to maximize the selling price of your car.  Low miles, cleanliness and unique features can all help.  Typically, the value that you will get from a dealer will not be the highest price.  Remember, auto dealers need to make a profit on your car when they sell it so they need to pay you a lower amount in order to achieve their goals.

Keep in mind that when you sell your vehicle, you may very well need to come up with cash. If the price you get for your car is less than the amount you owe, your bank will require you to pay that amount in order for them to release the lien and give clear title to the new buyer.

Trade-In Your Vehicle

Buying a new car and trading in your current vehicle is another way to get out from under an upside down auto loan.  This isn’t a magic bullet.  Essentially the negative equity in your current car is added onto the loan for your new car.  For example, let’s say that Sarah has negative equity in her current car totaling $2,500.  If Sarah trades in her car, she will either have to pay off the $2,500 or have it added onto the new loan.

Believe it or not, some lenders may be perfectly willing to finance your negative equity.  Ultimately, it helps them sell more cars and more loans.  If the value of the new car can support the additional debt load, trading in may be an option.  Sometimes, dealers can reduce the price of the new car you are buying by applying rebates and incentives.  This helps to “make room” for the negative equity you need to finance.  If you can, pay off the negative equity when you purchase the new car.  It can help you avoid getting into another upside down situation with the new auto loan.

How to Avoid an Upside Down Car Loan

Let’s wrap up by talking about how to avoid getting upside down in your car loan when you purchase a car. The good news is there are things you can do in order to reduce the chance that you get upside down on an auto loan.  The bottom line is you should to borrow as little as possible and pay it off as quickly as you can.

6 Tips to Keep In Mind

  • Make a large down payment – When you purchase a vehicle, put down the most you can. Every dollar you put down will reduce the amount you have to borrow.  The smaller the starting balance of your loan, the less likely you are to have negative equity.
  • Get a shorter loan term – Sign up for the shortest loan term that you can afford. While this will mean higher payments, you will be paying down your loan faster.  The temptation is always to have smaller payments to better manage your monthly budget.  Resist the temptation to pick longer loan terms.  They are much more expensive.
  • Purchase a used vehicle – Consider purchasing a used vehicle. The price of a used vehicle, even one a year or two old, already reflects the depreciation in value.  A lower price of the car means you are automatically borrowing a smaller amount.
  • Buy a car you can afford – When shopping, choose a car that fits your budget. Choosing a pricier model or trim package can increase the amount of the loan. Think carefully about adding on costly options that will increase the price of the car.  Be wary of additional service contracts and warranties that are offered to you as well.
  • Pick the lowest interest rate – In general, the lower your interest rate, the more of your monthly payment that goes to paying down your loan. You should shop for an auto loan as carefully as you shop for your vehicle.  This may mean considering a credit union or a local bank.  Don’t simply settle for whatever offer the dealer makes you.
  • Make extra payments  – Any extra payments you can make on your car loan will help you pay it off faster and reduce your loan. Sending in more than your monthly payment or making an extra payment will pay off in the long run.